How Does a Pension Plan Work After Retirement?
All your working life, you've heard about "the company pension plan": a tax-exempt, savings/investment account sponsored by your employer. It's there to support you in your old age – or, more specifically, once retirement day arrives.
Your retirement day is drawing near. What now? How does that nest egg you've nested for so long actually hatch?Brush-up on the Basics
Most employer-sponsored pension plans are qualified, meaning they meet Internal Revenue Code and Employee Retirement Income Security Act of 1974 (ERISA) requirements. That gives them their tax-advantaged status. Employers get a tax break on the contributions they make to the plan for their employees. So do employees: Contributions they make to the plan come "off the top" of their paychecks – that is, are taken out of their gross income. That effectively reduces their taxable income, and, in turn, the amount they owe the IRS come April 15. Funds placed in a retirement account then grow at a tax-deferred rate, meaning no tax is due on them as long as they remain in the account.
There are two main types of pension plans: defined benefit and defined contribution.
- About 90% of public employees, and roughly 10% of private employees, in the U.S are covered by a defined benefit plan, which typically pays out a monthly annuity based on the worker's salary history and number of years of service. Traditionally, these plans are entirely funded by the employer, but sometimes employees contribute as well.
- Defined contribution plans, which are much more common in the private sector, offer no set or predetermined payout. The amount you get at retirement is determined by investment results: the gains that have accrued in the account over the years. Typically, employees fund these plans, with their contributions matched to varying degrees by the employer. The best-known plan of this sort is the 401(k), and its cousin for non-profits' workers, the 403(b).
Some companies and government institutions offer both defined benefit and defined contribution plans. Your distribution choices at retirement will depend, largely, on the type of pension plan(s) you have. For more, see What's the difference between a 401(k) and a pension plan? Note: Though we've been using it as a generic term, "pension plan" in common parlance often means a defined benefit plan – the more traditional sort of pension, with a set payout, funded and controlled entirely by the employer.Defined Benefit Plans
With a defined benefit plan, you usually have two choices when it comes to distribution: periodic (usually monthly) payments for the rest of your life or a lump sum distribution. Some plans allow you to do both, i.e., take out some of the money in a lump sum, and use the rest to generate periodic payments. There will likely be a deadline by which you have to decide, and your decision will be final.
There are several things to consider when choosing between a monthly annuity and a lump sum.
- Annuity. Monthly annuity payments are typically offered as a single life annuity for you only for the rest of your life – or as a joint and survivor annuity for you and your spouse. The latter pays a lesser amount each month, but the payouts continue after your death, until the surviving spouse passes away.
Some people decide to take the single life annuity, opting to purchase a whole life or other type of life insurance policy to provide income for the surviving spouse. This may not be a bad idea if the cost of the insurance is less than the difference between the single life and joint and survivor payouts. In many cases, however, the cost far outweighs the benefit.
Can your pension fund ever run out of money? Theoretically, yes. But if your pension fund doesn't have enough money to pay you what it owes you, the Pension Benefit Guaranty Corporation (PBGC) could pay a portion of your monthly annuity, up to a legally defined limit. For 2016, the annual maximum PBGC benefit for a 65-year-old retiree is $60,136. Of course, PBGC payments may not be as much as you would have received from your original pension plan.
Annuities usually pay out at a fixed rate. They may or may not include inflation protection. If not, the amount you get is set from retirement on. This can reduce the real value of your payments each year, depending on how the cost of living is going. And since it rarely is going down, many retirees prefer to take their money in a lump sum.
- Lump Sum. If you take a lump sum, you avoid the potential (if unlikely) problem of your pension plan going broke. Plus, you can invest the money, keeping it working for you – and possibly earning a better interest rate, too. If there is money left when you die, you can pass it along as part of your estate.
On the downside: No guaranteed lifetime income, as with an annuity. It's up to you to make the money last. And, unless you roll the lump sum into an IRA or other tax-sheltered account, the whole amount will be immediately taxed and could push you into a higher tax bracket.
If your defined benefit plan is with a public-sector employer, your lump sum distribution may only be equal to your contributions. With a private sector employer, the lump sum is usually the present value of the annuity (or, more precisely, the total of your expected lifetime annuity payments discounted to today's dollars). Of course, you can always use a lump sum distribution to purchase an immediate annuity on your own, which could provide a monthly income stream, including inflation protection. As an individual purchaser, however, your income stream will probably not be as large as it would with an annuity from your original defined benefit pension fund.Defined Contribution Plans
With a defined contribution plan, you have several options when it comes time to shut that office door.
- Leave In. You could just leave the plan intact and your money where it is. You may in fact find the firm encouraging you to do so (see 401(k): Pressure's On to Leave It at Your Old Job). If so, your assets will continue to grow tax-deferred until you take them out. Under the IRS' required minimum distribution rules, you have to begin withdrawals once you reach age 70½. There may be exceptions, however, if you are still employed by the company in some capacity.
- Installment. If your plan allows it, you can create an income stream, using installment payments or an income annuity – sort of a paychecks-to-yourself arrangement throughout the rest of your retirement lifetime. If you annuitize, bear in mind that the expenses involved could be higher than with an IRA.
- Roll Over. You can roll over your 401(k) funds to a traditional IRA, where your assets will continue to grow tax-deferred. One advantage of doing this is that you will probably have many more investment choices. You can then convert some or all of the traditional IRA to a Roth IRA. You can also roll over your 401(k) directly into a Roth IRA (see 401(k) Rollover: Pick Roth IRA or Traditional IRA). In both cases, although you will pay taxes on the amount you convert that year, all subsequent withdrawals from the Roth IRA will be tax-free. In addition, you are not required to make withdrawals from the Roth IRA at age 70½ or, in fact, at any other time during your life.
- Lump Sum. As with a defined benefit plan, you can take your money in a lump sum. You can invest it on your own or pay bills, after paying taxes on the distribution. Keep in mind, a lump sum distribution could put you in a higher tax bracket, depending on the size of the distribution.
Deciding what to do with your pension, like most financial decisions, is complicated and depends on your individual situation. There is no one size fits all solution to these matters. But there are common elements everyone should consider, and not just financial or budgetary ones. Your current state of health and your anticipated life span, based on family history, can make a big difference, especially when choosing between an annuity and a lump sum distribution. The amount of debt you hold, including mortgages, can also play a role (for related reading, see: Should Retirees Still Have Mortgages?).
Study your options, consult with a trusted financial planner and start the process well in advance of R-Day to ensure appropriate coordination with other important decisions that hit folks approaching the retirement years, such as taking Social Security benefits and signing up for Medicare.